Texas Chemicals is a major producer of oil-based fertilisers in the US. The company’s stock is currently selling for $80 per share and there are 10 million shares outstanding. The company also has debt outstanding with a market value of $400 million. The company’s current capital structure approximates well its target position. The company’s equity beta is equal to 2.0.
The company is considering an expansion project which is expected to generate a rate of return of 20% annually. Assuming a corporate tax rate of 50%, risk free rates of 8%, and the expected rate of return on the market portfolio of 17%, determine whether the company should go ahead with the project under the following scenario:
The project’s risk is different (larger) from that of the company. The project’s unlevered beta is 2.5. Also, consistent with its higher risk level, the project is expected to generate a rate of return of 25%. Further, as a result of the project’s higher risk level, the company has decided to use a more conservative capital structure represented by a debt-to-asset ratio of 15%.